We just closed down 512 points on Dow yesterday. The Dow has dropped approximately 1,350 points in 10 trading PIMCO 2011.082011.08.04 NY Times European Bankssessions. It was up only once in the last 10 trading sessions. It has dropped approximately 10.5% and is now officially in “correction” territory, along with most other stock indices. Most, but not all, technical and sentiment indicators are deeply over sold and at an extreme level. We are probably within a few days of a good short term low if we are not already there. In this panic type environment, if you are off by a day, you could be off 500 or more points. This is one of those very unusual and infrequent (thankfully) times were the markets are in a free fall. We are at areas that should begin to provide support for the stock market. But in a panic, markets can easily go further down than fundamentals or technicals would normally predict. In my opinion, this is not the time to panic.

When we had our last quarterly call in early May when I discussed the very likely possibility of a summer correction of 10 – 20%. We discussed that you should always have at least one year’s worth of cash on hand for all expenses so that you would not have to raise cash in a down market (such as this). We have now hit my first minimum target of 10%. This is not surprising or unexpected as we discussed. There could certainly be a short term trading opportunity coming up, but I would wait for some time and price stabilization before I would recommend making any long term asset allocation changes.

The old market adage that we discussed of “sell in May and go away” has worked again. A disproportionate number of market lows are made in the May through October time period. We are only in the middle of the time period and only at the minimum pullback percentage, so I would not recommend any long term allocation changes at the moment. This drop has been so sharp and fast that the panic and pessimism is just starting to build – it is not at an extreme yet. You want that extreme to begin to develop more fully before making long term allocation changes. Right now, this is just a normal, every day 10% correction, though the way that it occurred was unusual. There are definitely structural issues in Europe and within the US itself that are providing the catalyst for this move. I do not know how these will play out. My focus will be on trying to spot the indications of a longer term bottom as they occurring, such as we did in March 2009. We don’t need that extreme in price or sentiment, but we want to get to the point where investors give up on stocks again. We are not that close at the moment in my opinion. In summary, we have a violent short term low coming in very soon and I would expect a very sharp short term bounce before a likely calming down in volatility and a potential retest of whatever lows we hit. When your friend at the cocktail party tells you he is getting killed in the stock market, that he thinks that the market will not ever go back up again and that he cannot take it any more, then you buy and change your long term asset allocation. The same situation would apply if it is you and not your friend.

Watch for these types of stories in the newspapers and on TV. When a strong belief sets in among the general population and non investing population that the market can only go down and only an idiot would invest in it after how poorly it has done for so long, then you should strongly consider increasing your long term equity allocation.

 

I wanted to include some additional comments.

1.  The faster and farther a diversified portfolio of stocks / the market drops, the more it is lowering the risk of a new investment going forward (it does not change the fact that you lost money on the investments that you owned on the way down, but that is irrelevant.  You cannot change that, you can only change what you do going forward.  Focus on things that you can change, not the things that you can’t, and have the wisdom to know the difference). One thing I can guarantee you – the Dow has 512 less points of downside risk today than it had yesterday and about 1,350 points less downside risk than it had 2 weeks ago. A drop in stock prices essentially pulls forward potential future losses and puts them in to the present time period. Therefore, there is less price risk going forward from this new lower level. It is simple math, but people forget this. A simple example is a house. If you can buy the same house for $400,000 instead of $500,000, you have less risk. The stocks you are buying today are the same stocks that you would have bought yesterday 512 points higher.

What has changed today is the perception about future earnings and the addition of fear. For those changes, you get a 512 point discount in your purchase price. As I stated frequently during the spring of 2009, stocks trade on the second differential – the change in the rate of change. For example, if investors are now pricing in a 20% drop in earnings and there is only a 10% drop that actually occurs, the stock market will rally. The lower the investor expectations, as reflected in pessimism and lower stock prices, the more likely it is for fundamentals over time to outperform the low expectations. Or as I like to say, if you set the bar low enough, eventually you will be able to simply trip over it.

2.  Critical bottoms are normally made when investors completely give up on future upside in stocks and only worry about future downside. They know that the market is significantly off of a prior high, but their only focus is to sell now at this lower level before the market goes even lower. This is the key psychological point to look for at all market lows in all different markets. That is the point where fear and emotion overtake rational thought and fundamentals. That is when you must be there with a clear head and cash available to take advantage of the errors of others.

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